The Fed: Emerging economies should be able to weather Fed tightening, Powell says

Emerging markets should be able to weather the storm of Federal Reserve tightening because they’ve started drawing in capital again and their economies are improving, a leading Federal Reserve official said Thursday.

Speaking to the annual meeting of the Institute of International Finance, Fed Gov. Jerome Powell said he expects the challenges posed to emerging economies from the normalization of global financial conditions will be “manageable.”

Powell’s comments are notable as he’s considered a top contender to get the Federal Reserve chairman role when Janet Yellen’s term expires in February. Powell reportedly has met with President Donald Trump to discuss the top job.

Powell acknowledges that, in the past, capital flows to emerging economies could be at risk when the U.S. and other industrialized nations tighten monetary policy, by encouraging capital to return to advanced economies, putting downward pressure on emerging market currencies and enlarging emerging economy debt burdens.

As emerging economies have improved — the downward trend in China has flattened, Brazil has moved into recovery and other countries have picked up — capital flows to emerging economies have rebounded.

Powell says what’s important is the state of economic fundamentals in the emerging economies themselves. One index which measures emerging market vulnerabilities finds them lower now than in the 1990s, though trending up since 2008.

While risky emerging economy corporate debt has almost tripled since 2011, it’s still much lower than just before the Asian crisis, at 30% of GDP now compared to around 46% then. “The situation is not alarming, but risks are significant and bear close watching, especially in China,” he said.

The other key, Powell says, is that U.S. monetary policy normalization has been and should continue to be gradual. As long as global financial conditions normalize in an orderly fashion, emerging economies should have sufficient time to adjust, he said.

The biggest risk could come from market turbulence.

“Risk sentiment is holding up, credit spreads in emerging markets have been declining, equities are up, long-term yields have hardly budged, and the dollar has been declining. Markets, however, can turn on a dime, and reactions can be outsized. This concern may be especially relevant at present, given the low level of volatility and elevated asset prices in global markets, which may increase the likelihood and severity of an adjustment,” he said.